Abnormal return is a term used in finance to describe the difference between the actual return of an investment and the expected return. The expected return is calculated based on the historical data of the investment, the current market conditions, and the performance of the broader market. If the actual return is higher than the expected return, it is called a positive abnormal return, while a lower actual return is called a negative abnormal return. In this article, we will discuss the causes and examples of abnormal returns.
Causes of Abnormal Returns
- Company-specific news or events: Company-specific news or events, such as a new product launch, earnings report, or merger, can affect the stock price of a company. If the news or event is positive, it can result in a positive abnormal return. On the other hand, negative news or events can result in a negative abnormal return.
- Market-wide events: Market-wide events, such as changes in interest rates, political instability, or global economic conditions, can affect the stock prices of all companies in the market. If the event is positive, it can result in a positive abnormal return for all companies. Conversely, negative market events can result in a negative abnormal return for all companies.
- Information asymmetry: Information asymmetry occurs when some investors have access to information that is not available to the general public. If these investors trade based on this information, it can result in abnormal returns for their trades.
- Behavioral biases: Behavioral biases, such as overconfidence, herd mentality, or anchoring, can cause investors to make irrational investment decisions. These decisions can result in abnormal returns.
Examples of Abnormal Returns
- Company-specific news or events: One example of a positive abnormal return due to company-specific news is when Apple announced the launch of its first iPhone in 2007. The stock price of Apple increased by more than 8% on the day of the announcement, resulting in a positive abnormal return. On the other hand, when Volkswagen was found to have cheated on emissions tests in 2015, the stock price of Volkswagen decreased by more than 20% on the day of the announcement, resulting in a negative abnormal return.
- Market-wide events: One example of a positive abnormal return due to a market-wide event is when the Federal Reserve announced a cut in interest rates in 2020. This announcement resulted in a positive abnormal return for all companies in the market. Conversely, when the global financial crisis occurred in 2008, it resulted in a negative abnormal return for all companies in the market.
- Information asymmetry: One example of abnormal returns due to information asymmetry is when a company insider trades based on non-public information. In 2014, a former executive of a biotech company was found guilty of insider trading, resulting in a negative abnormal return for the company’s stock.
- Behavioral biases: One example of abnormal returns due to behavioral biases is when investors follow the herd mentality and invest in a particular stock without conducting proper research. This can result in a positive abnormal return for the stock, which may not be sustainable in the long run. An example of this is the dot-com bubble in the late 1990s, where investors invested heavily in internet companies without proper research, resulting in a positive abnormal return for these companies until the bubble burst.
Conclusion
Abnormal returns can result from a variety of factors, including company-specific news or events, market-wide events, information asymmetry, and behavioral biases. It is important for investors to understand the causes of abnormal returns and to consider them when making investment decisions. Investors should conduct proper research and analysis before investing in any stock to avoid making irrational investment decisions that can result in abnormal returns that may not be sustainable in the long run.
